Westpoint investors thought they were investing in a safe portfolio of properties across Australia, which would deliver them a 12 per cent annual return. But it turned out the investors actually invested in mezzanine companies, which sat between the investors and the properties. The mezzanine companies had no assets and offered no security.
Fincorp promoted itself as a boutique funds management and property development company offering first mortgage, mezzanine and bridging finance for property developments, plus it had its own property holdings. Fincorp raised capital by offering a variety of unsecured and secured notes and debentures to fund its property ventures, offering investors a 9.75 per cent a year return.
The company's advertisements reassured investors they could "invest with certainty" and "sleep soundly at night". Neither statement was true. "The maximum rate where you can sleep soundly at night - the virtually zero-risk rate - is about 6.5 per cent," Secure Investments FIB director Stiven Laszlo says.
"That's the bank-deposit, rated-debenture, low-risk end of the market. A non-bank finance company, somebody like RACV Finance, will give you 6.8 per cent on a secured debenture for a year. High yield starts there - if you want to look for anything higher, you're going further out the risk curve." Grange Securities head of investment management Frank Sciarrone says there is nothing wrong with using property-based securities as yield investments.
"You can get 8-9 per cent a year in unlisted property vehicles, where you can see the tenancy profile, you can see where the cash flows are coming from. That's traditional passive property investment. But investors have to understand that the underlying rental stream is probably under the cash rate and the bulk of the return being achieved is through capital growth. That's not reliable and it's not high-yield investing," Sciarrone says. High-yield investing means investing in credit, he says. "You're moving into corporate debentures and bonds, listed hybrid securities and unsecured notes, floating-rate securities, unsecured debt, asset-backed securities, collateralised debt obligations (CDO) and structured securities, all of which have varying degrees of credit risk," he says. He says the high-yield market became popular about eight years ago when it was a different market. "Because interest rates have been low, investors have looked for other alternatives to invest their cash at increased yield. From 1998 to 2001 there was a lot of issuance of hybrid securities on the stock exchange at a time when high-yield spreads were historically high," he says. "Investors got real benefit in investing in hybrid securities then, but spreads have ground back ever since, and they're now at historical lows. Investment-grade hybrid securities that were being issued at 250 basis points above bank bills are now being issued at 100-110 basis points above bank bills. So the hybrid securities market is not high yield anymore - it's just good yield."
The market is now dominated by strong investment-grade issuers, he says, for example IAG (Insurance Australia Group). "When you step up from that safe 6.5-6.8 per cent range into securities issued by investment-grade counterparties, these days you're really only talking about a 1-1.5 per cent pick-up from bank bills," he says. "At 6.4 per cent on bank bills that gives you about 7.4-7.5 per cent. Most of the issuers are issuing floating-rate securities rather than fixed-rate. There might only be 5 per cent cash-flow return and the rest of the return built into a franking credit."
FIIG Securities managing director Jim Stening says most of the major banks and insurance companies have listed hybrid securities. "They're offering running yields of 7-8 per cent at the moment. The unrated ones are offering 8-10 per cent. Because there's so many investors clamouring for yield, and some of the yields get driven down by that strong support," Stening says. "The Myer notes, for example, came onto the market with a 10 per cent coupon and they've rallied hard, and the running yield is now about 8.5 per cent." He says the investment-grade listed hybrid securities sit at the upper end of the risk echelon in fixed interest, but are a good port of call for smaller investors who are prepared to take a bit more risk to get a better return.
"I think with the listed debentures, corporate bonds, hybrids, listed securities, a responsible and diversified portfolio would look to get about 1-1.5 per cent above bank bills - so about 7.3-7.8 per cent. You could sleep well at night on that," he says. Tony Lewis, managing director of fixed-income brokerage Lewis Securities, says the secondary market for listed interest-bearing securities offers some tempting yields, with commensurate risk. "On some of them, the Timbercorp Notes and Timbercorp Orchard Trust debentures, the Great Southern Plantations Reset Convertible Notes and the Allco Hybrid Investment Trust, you can pick up running yields of 8-11.5 per cent at the moment. But you're going up the credit rating curve, and the risk curve moves the same way," Lewis says.
He says a yield portfolio could be put together at present that delivered about 8-10 per cent a year. "You could do that using some of these high-yielding listed securities and some of the unlisted property trusts, where you can get 8-9 per cent," he says. "But why would you go to the bother of putting that sort of portfolio together when many of the high-yield funds can give you 7-9 per cent a year, with a good spread of underlying investments, professionally chosen and managed." Sciarrone agrees. "Selection of credit and diversity within a portfolio is paramount. Really, a high-yield fund is your best way to do it. Doing it yourself, you don't have as much going for you in a market sense as you had eight years ago," he says. The best-performing high-yield funds, according to research house Morningstar, are the Austock High Yield Fund, which returned 15.1 per cent after fees in the year to April 30, 2007, and the Kinsmen Mezzanine Fund, which earned 13.5 per cent. The median return (of those funds with a one-year return) was 7.44 per cent. "The large high-yield funds, run by the likes of Challenger , UBS, Schroders and AMP, aren't giving you that level of return, but they're much more diversified. We run a hybrid securities fund that has 70 different investments and in the year ended March it returned a net 8.6 per cent. With a judicious spread of high-yield funds, and maybe some direct listed investments, a portfolio yield of 8-8.5 per cent after fees can be achieved with reasonable safety," Sciarrone says.
Graham Rich, managing director of research firm Portfolio Construction Forum, says that in spite of their complexity, some of the CDOs are a better alternative for yield-oriented investors than some of the simpler products. "The listed CDOs offer some of the best yields for their credit rating and some of the best credit ratings for their yields," Rich says. "There have been some default issues - which you'd expect, and the possibility was spelled out to investors - within some of the CDO products, but the theory is that the spread of risk within a CDO gives you the upside with not all of the downside.
"If you're looking at high-yield investments on a portfolio approach and you put that kind of internally-diversified asset in another level of diversification, it can work quite well. If you have some of the listed CDOs and notes, and you have maybe some unlisted property investments offering 9-11 per cent, I think you can get a portfolio yield of 10 per cent without single-product risk." At present, the running yields on Australian Securities Exchange-listed CDOs range from 7.77 per cent a year to 11.63 per cent, with the higher running yields reflecting incidents of credit stress. But Sciarrone says overall, despite a few defaults, the listed CDO structures have worked. Rich says: "In the secondary market, some of the floating margins over bank bills are getting up for double-digit territory. If you look at some of the shorter-dated securities, some of the ones that were issued three or four years ago, and have two years to go, they can look pretty good.
"For example, one of our CDO issues, the HY-FIs Series 4 are sitting on 90-day bank bills plus 4.2 per cent, which is effectively a yield to maturity of 10.6 per cent. It had one default, Parmalat, which happened quite early. The risk that you take in CDOs is that there will be more defaults than the buffer, so you don't want to see early defaults. But nothing in that CDO has defaulted since then, and because it only has until October 2008 to run, at this point in time it looks a pretty reasonable investment for the risk rating that it now holds - it's paying 10.6 per cent and it's rated BB+. Similarly, another of our issues, Mahogany Series 1, is trading at a yield to maturity of 180-day bank bills plus 4.8 per cent, which equates to 11.24 per cent for an A- security."
But if an investor doesn't understand how a CDO works, Sciarrone says they shouldn't be investing in it - unless through a fund. "Another good rule is that if you're getting 10 per cent from something in your portfolio, you don't want 10 per cent of the portfolio in it," he says. If you're going to invest in leveraged credit, Stening says it is critical to do it through a good manager. "We're distributing a couple of products that we think are almost a new era in fixed-income investing, because they're capital guaranteed, and they're targeting a yield that competes with an outright equity investment," he says. "What we wanted to do was get some of the best fixed-income fund managers in the world and build a product that enables Australian investors to get access to those assets. We've got a retail deal that Credit Suisse has launched called the Infiniti Capital Fixed Income Fund, which references three PIMCO fixed-income funds. The investment objective of the fund is to produce consistent returns of 3 per cent a year above the one-year bank bill swap rate, so at present, that would imply 9.3 per cent a year. With the capital guarantee, we think that's pretty attractive."
Investec Private Advisers head Robert Lipman has generally placed clients into a combination of listed floating-rate, fixed-interest securities that are well-rated. "We like to see good credit risk, where the yields are set as a margin to the bank bill rate. The IAG convertible preference shares are a good example: the security is reasonably well-cushioned against a rise in interest rates because the link is to the 90-day rate. You won't have the same volatility in prices if interest rates did go up and it pays a rate above the cash rate," Lipman says.
He has supported CDOs "selectively", but leans toward the use of specialist funds to cover the exotic end of the interest-bearing market. "We use the Basis Capital Yield Fund, which invests in overseas CDOs, and that has a very good three-year track record, delivering well above 10 per cent a year. People have to understand the risks they're taking in those things, but if you've got very good management and very strong credit risk, experts in those can selectively provide a different exposure to Australian fixed-interest markets, and that can be a reasonable strategy on the high-yield side," he says.
"Another fund that has worked very well for us is the Kaplan Income Fund, which focuses on Australian high-yield listed fixed interest and property funds, listed and unlisted, and high-yielding shares. Again, we use that selectively, but it has tended to return 8-10 per cent a year for a number of years. For what you get, which is a focus on income, it's a highly diversified play that I think is suitable for portfolios seeking high income for less risk."
For a yield-oriented investor, Lipman says the portfolio yield that can be achieved depends very much on the risk that they're prepared to take. "If the client is risk averse and want only the highest credit quality, you might be looking at 1 or 2 per cent above the cash rate. But I think that 8 per cent is a reasonable expectation for the return from an income-style portfolio. If you're looking at much higher than that on an income portfolio, you've got to assess the risks inherent in that portfolio because there are very few free lunches out there," he says. Mortgage funds go high octane
Until recently, conservative investors who wanted a better return than cash, without taking bond market or sharemarket risk, found a sound candidate in mortgage funds investing in 'first mortgage' property loans secured against retail, office/commercial, industrial and residential investment properties.
In recent years, however, a newer, more entrepreneurial breed of mortgage fund has emerged, which also invests in mezzanine debt (second mortgages), lends for riskier construction financing and is prepared to lend on far higher loan-to-value (LVR) ratios. This widening of the sector has stretched the spectrum of return - but also the risk. According to research house Morningstar, of the 47 mortgage funds that have one-year returns at April 30, 2007, the after-fees returns range from 5.20 per cent to 9.84 per cent, with an average return of 6.62 per cent.
The problem for investors is that five years ago, the mortgage fund sector only consisted of very conservative funds. Now there is an active category of higher-octane funds that give a higher return - but take on a lot more risk to achieve that. This extra risk can come in a variety of forms. The fund may have a high proportion of its lending as second mortgages (also referred to as mezzanine or subordinated debt) over properties, which are more risky than first mortgages. The fund may lend for development or construction activities, which add to the risk; or lend on a much higher LVR than a traditional fund. Where a traditional mortgage fund might cap its LVR ratio at 67 per cent, a more aggressive fund might be prepared to lend at an LVR of 90 per cent. The latter will charge an extra 1 per cent on its loans, but the loan is a more risky prospect.
Also, a high-return mortgage fund may not be anywhere near as well diversified as the funds it is outperforming. The $32.3 million Teys Income Builder (the former Heritage National Mortgage Fund), for example, lends money for the construction of retirement income. About 82 per cent of its loan book (which comprises 15 individual loans) is on projects in Western Australia, with the balance located in Queensland. The Teys Income Builder was the top-performing mortgage trust for the 12 months to April 30, 2007, earning an impressive 9.84 per cent after fees. Most larger mortgage funds will be much more diversified in every sense: by number of loans, type of property and geographically. For this reason, they will struggle to match the return of the Teys Income Builder - but they can be considered far less risky.
Researcher Standard and Poor's, for example, now divides the mortgage fund sector into three sub-categories: conventional (first-mortgage loans over residential and commercial properties, less than 30 per cent in construction, development or specialised property lending), maximum LVR of 75 per cent); hybrid (first-mortgage loans over residential and commercial properties, less than 30 per cent in construction, development or specialised property lending, maximum LVR of 75 per cent and a strategic allocation of 30-50 per cent to non-mortgage-backed fixed-interest assets) and high-yield (first and subsequent mortgage loans over residential and commercial properties, more than 30 per cent in construction, development or specialised lending, and maximum LVR of more than 75 per cent). Morningstar is following suit, dividing the mortgage trust category into traditional conservative and aggressive.
